Spain's bailout conundrum

As Spanish banks' bad debt hits an 18-year high, Madrid is seeking a change to Europe's bailout fund which would enable it to lend directly to financial institutions.

Will Spain be forced to seek a bailout to prop up its debt-ridden banks?

Angst about the dire state of the Spanish banks increased overnight after fresh figures showed that their bad debts have climbed to the highest level in around 18 years. According to the figures from the Bank of Spain, 8.16 per cent of the loans held by Spanish banks – or €143.8 billion ($US188.7 billion) – were at least three months late in their repayments in February.

Spanish banks have been hit with crippling losses on their loans to construction companies and property developers since the country’s massive real estate bubble burst in early 2008. But many predict that the banks’ problem loans will surge even further as the Spanish economy falls deeper into recession, and as housing prices continue to fall.

Figures released by the Spanish government overnight show that the fall in Spanish house prices is picking up pace. House prices in the first three months of this year were 7.2 per cent down from their level a year ago, and 3 per cent lower than in the final three months of 2011. All the same, many analysts believe that Spain’s housing market remains overvalued, and that housing prices could suffer further sharp declines as the country falls deeper into recession, and unemployment pushes even higher.

Many critics argue that the ECB’s move to douse the European banking system with €1 trillion in cheap three-year loans has put the Spanish banks in an even more fragile financial position. Spanish banks were able to use the ECB money to play the 'carry trade'. They borrowed from the ECB at a 1 per cent interest rate, and earned a handsome profit by investing the money in high-yielding Spanish government bonds, and for a while this stabilised Spanish bond markets.

But investors are now worried that Madrid will fail to meet its deeper ambitious plans to reduce the budget deficit from 8.5 per cent of GDP in 2011 to 5.3 per cent this year. As a result, they’ve been dumping Spanish bonds, which has pushed bond prices sharply lower and sparked fears that Spanish banks now face hefty massive losses on their bond portfolios.

Some analysts estimate that the Spanish banks could need a capital injection of at least €200 billion to cover their losses they’ve suffered on their real estate and bond portfolios.

Alarmed about the parlous state of the Spanish banking system, the Spanish government led by Mariano Rajoy is pushing for a major change in the eurozone’s bailout fund, which would allow the fund to lend directly to banks. According to a report in the German newspaper Sddeutsche Zeitung, the idea of changing the rules on the bailout fund enjoys the backing of several other eurozone countries, and some senior European Central Bank officials.

According to the newspaper report, the Spanish government wants the rules changed so that the Spanish banks can borrow directly from the bailout fund. So far, bailouts have only been provided to eurozone governments, which have then used some of the funds to provide assistance to their troubled banks.

Relaxing the rules would allow the Spanish government to deal with the country’s banking crisis without plunging the country into a humiliating, full-scale bailout, which would inevitably involve Spain being forced to adopt even more draconian savings and reform measures. Some senior European Central Bank officials also support the idea because it would help reduce growing tensions in the European financial system.

But Germany, which is the biggest contributor to the bailout fund, has flatly rejected the idea. Berlin is worried that the new plan would mean that it would no longer be able to force debt-laden countries to push through tough reforms in exchange for receiving a bailout. What’s more, the bailout fund would suffer hefty losses if the banks that borrow from the fund ultimately collapse.

"Spain doesn't need an aid program, and if it were to need one, then only under the known conditions," a German government source told the Sddeutsche Zeitung.

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